Changes could woo back small investors

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The Independent Online
ARE YOU a convert to the cause of investment trusts? If so, you might be forgiven for feeling slightly disgruntled in recent years, as the value of your investment has failed to match rises in other equity- linked pooled funds, such as unit trusts.

That isn't true of all investment trusts, of course. Some have continued to perform well and, in a handful of cases, have delivered sparkling returns. But it is true to say that in many cases, returns have been relatively poor.

In part, this has not been so much because of poor fund management skills, but a consequence of the structure of investment trusts themselves.

Unlike unit trusts, investment trusts operate as companies in their own right. You buy shares in an investment trust, which in turn buys shares in other companies. Demand for an investment trust share is what drives its price, not the value of the underlying asset.

In fact, it is common for the value of assets held by an investment trust to be greater than the price of shares in the trust itself. When this happens, this is known as a "discount to net asset value", or NAV.

This discount can narrow or increase, according to demand. Back in the early to mid-1990s, it narrowed so that the NAV discount stood at an average of 5 per cent. For investors who bought into investment trusts in the preceding few years, this was an unqualified success story.

Not only did they gain in terms of increases in the value of their trusts' underlying assets, the narrowing of discounts from up to 25 per cent a decade earlier gave them a substantial second bite at the cherry. The problem, unfortunately, was that this could not last.

A combination of factors, including the launch of too many poorly performing investment trusts, greater marketing skills by their unit trust counterparts, and more recent bouts of turbulence in world equity markets, saw discounts widen again to up to 15 per cent. In other words, irrespective of a trust manager's asset-picking skills, the trust's value fell to up to 10 per cent less on average than a comparable unit trust.

The problem is compounded by the fact that around 60 per cent of the pounds 54bn investment trust sector is owned by institutional shareholders. They might have invested at a time when their own institution did not have the research expertise in a particular area. But this is no longer the case and - according to some estimates - anything between 25 and 35 per cent of them would like to sell, creating between pounds 13bn and pounds 18bn of pent-up selling demand.

The trick, then, is for investment trusts to substitute departing institutional shareholders, who would sell up if discounts were likely to narrow, with a new band of "committed" shareholders.

One mechanism is to maximise small investment opportunities, including regular savings schemes in investment trusts. In this regard, the Government's decision to encourage the provision of a new unit and investment trust- linked personal pension is judged by many experts to have the potential to mop up some of the shares which institutions might wish to dispose of.

But without small shareholders seeing that serious steps are being taken to overcome the problem of discounts to net asset value, they are unlikely to step in to any great extent.

Therefore, one of the main methods which investment trusts hope will help the sector to overcome the discount problem is to engage in mass share buy-backs.

Investment trusts are allowed to buy back up to 14.99 per cent of shares at present held by shareholders, if they are given authority to do so. In the past year or so, more than 100 trusts, one-third of those that can do so, have sought, or are seeking, the authority of their shareholders to buy back their own equity. By reducing the number of shares in existence, the aim is to increase the price of those still in circulation. More than 20 have already acted on the basis of this general authorisation.

The attractiveness of this generalised buy-back has increased since the beginning of this year, when Advance Corporation Tax was abolished. The abolition will allow investment trusts to buy back their shares without incurring a 25 per cent liability to tax on the difference between the price paid and the price at which the shares were originally issued.

Ultimately, although buying back shares may work in some cases, overall performance of a trust is likely to remain key to reducing discounts. Replacing institutional shareholders with long-term investors requires a combination of reforms to the sector - including dealing with the problem of heavy expense ratios in very small and relatively unsuccessful trusts.

If the reforms work, small savers could well see their investment trusts becoming viable alternatives to unit trusts and their intended replacements, open-ended investment companies. The next 18 months will be a make-or- break time for the sector.

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